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The Role of Collusion Between Management and Board Of View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Research Papers in Economics Journal of Economic Behavior & Organization Vol. 42 (2000) 427–444 When to fire bad managers: the role of collusion between management and board of directors Roel Beetsma a, Hans Peters b,∗, Eugène Rebers c a Dutch Ministry of Economic Affairs CEPR, Den Haag, The Netherlands b Department of Quantitative Economics, University of Maastricht, P.O. Box 616, 6200 MD, Maastricht, The Netherlands c Dutch Ministry of Finance, Den Haag, The Netherlands Received 28 April 1998; received in revised form 26 May 1999; accepted 27 May 1999 Abstract We develop a model in which a shareholder hires a director to monitor a manager who faces stochastic firing costs. We study the optimal incentive scheme for the director, allowing for the possibility that the manager bribes the director in order to change his firing intentions. Such collusion may be in the interest of the shareholder, because it avoids the need to (ex ante) compensate the manager for very high realisations of his firing costs (these are precisely the cases in which collusion occurs). © 2000 Elsevier Science B.V. All rights reserved. JEL classification: J33; L22 Keywords: Corporate governance; Hierarchies; Incentive compensation; Collusion; Board of directors 1. Introduction Even among capitalist economies, there are pronounced differences in the way corpora- tions are run. In the US and the UK, for example, most of the large firms are supervised by a Board of Directors (BoD). The BoD is composed of outside directors as well as executive directors, who are involved in the day-to-day management of the firm. The ultimate power, however, rests with the shareholders, who always have the possibility to fire the manage- ment. The Anglo-Saxon system is therefore often cited as an example of how corporate governance should be organised in countries where shareholders have much less influence on the way the company is run. In Germany and the Netherlands, it is common to have a separation between the manage- ment and the BoD. In such a two-tier system, the BoD often acts as an autonomous body ∗ Tel.: +31-43-388-3834; fax: +31-43-388-4874. E-mail address: [email protected] (H. Peters) 0167-2681/00/$ – see front matter © 2000 Elsevier Science B.V. All rights reserved. PII: S0167-2681(00)00098-6 428 R. Beetsma et al. / J. of Economic Behavior & Org. 42 (2000) 427–444 which is beyond the control of the shareholders. 1 It is frequently argued that this lack of shareholder power gives rise to situations in which the management and the BoD mutually protect each other at the expense of the shareholder. 2 In this paper, however, we argue that such collusion between management and directors is not always bad for the shareholders. To show why this may be the case, we consider a simple two-period model of a firm which hires a manager at the start of the first period. The match between the manager and the firm may turn out to be either good or bad. The quality of the match is beyond the control of the manager or the firm: it is merely a ‘move by Nature’. If the match is bad, the shareholder would like to fire the manager at the end of the first period. 3 At that moment, the manager learns about the size of a personal cost that he will incur in the event of being fired. In practice, the firing cost can take several forms. For example, it may capture foregone income as well as the loss of resources in the process of searching for a new job and moving to another place. But there may also be other, less tangible costs, such as the loss of reputation and valuable contacts. It is reasonable to assume that these costs are, at least partly, unknown ex ante, for example because it is not clear what the manager’s job market position or legal position will be in the future. However, for the manager to be willing to run the firm, he needs to be ex ante compensated for his expected firing cost. In the ideal situation, the shareholder would observe this firing cost also and be able to commit ex ante to not firing the manager in those cases in which his firing cost exceeds the expected gain from hiring a new manager. Rather realistically, we assume that the shareholder can only learn about the quality of the match through the observation of the firm’s first-period cash-flow. Moreover, the shareholder does not observe the realisation of the firing cost. Therefore, the shareholder may want to delegate the power whether or not to fire the manager to a director who monitors the company more closely and thus can make better informed decisions. If the firing cost of a (bad) manager turns out to be relatively high, he has the incentive to bribe the director not to fire him. The possibility of such collusion may be in the interest of the shareholder, because it saves him the resources needed to compensate the manager it ex ante for potentially high realisations of the firing cost. Thus, collusion avoids part of the deadweight losses associated with firing decisions. The model is primarily meant to analyse a two-tier corporate governance system, in which the BoD (the Supervisory Board) is independent of the management and thus has the power to fire the management. It could also apply to a one-tier system if the Board includes a number of outside (non-executive) directors, who perform a monitoring role similar to the one carried out by the BoD in the two-tier system. In that case, the outside directors might be bribed by the executive directors to induce them to fulfil their monitoring role less zealously. However, a crucial assumption for the results to hold is that the BoD be 1 In the Netherlands, only the BoD has a right to appoint or to fire the management. The BoD also appoints its own successors, without interference from the shareholders (see, for example, Moerland (1995)). 2 Examples for the Netherlands are the companies Nedlloyd, Vie d’Or and Bobel. In the cases of Nedlloyd (Volkskrant, 1993a) and Bobel (NRC, 1996), directors failed to exert sufficient control, while in the case of Vie d’Or, directors and managers were involved jointly in outright fraud (Volkskrant, 1993b, 1997). Of course, only cases that end badly get attention from the media. Examples of beneficial collusion between management and BoD rarely get into the press. 3 With some slight abuse of terminology, we will refer to the manager as being good (bad) if the quality of the match between the manager and the firm is good (bad). R. Beetsma et al. / J. of Economic Behavior & Org. 42 (2000) 427–444 429 independent of the shareholders. If not, as is usually the case in the one-tier system, the way it is applied in the US and the UK, the possible collusion mechanism would break down. The reason is that the shareholders can always get rid of a bad manager, no matter how large his personal firing cost is. In the two-tier system, a breakdown of the mechanism is likely if large shareholders are represented on the Board. The size of the bribe needed to compensate such Board members for the expected loss from retaining a bad manager may well be too large for him to pay. In the model, we assume that the Board is independent, and hence, that large shareholders are not on the Board. For simplicity, the model assumes that collusion between the manager and the director takes place through a monetary transfer from the former to the latter. In reality, however, such a bribe would often be less tangible. For example, in a corporate system with inter- locking directorships and strong informal ties across firms the manager might recommend the director at other firms for a directorship. Another example would be a tightening of buyer–seller relations between the manager’s firm and firms in which the director has a stake or of which he is manager himself. To focus on the question under what circumstances collusion can be beneficial, we keep the model as simple as possible by ignoring the effect that manager effort can have on the firm’s performance. However, there is large principal-agent literature that focuses on designing compensation schemes that a shareholder can use to extract the optimal level of effort from a manager. 4 This standard model has been extended to incorporate a supervisor as another layer between the principal and the agent (e.g. Baron and Besanko, 1984). According to Kofman and Lawarree (1993), however, ‘the research in this area has by and large neglected the possibility of collusion.’ An important exception is Tirole (1986), who adds a set of ‘coalition incentive compati- bility constraints’ to the usual individual rationality and incentive compatibility constraints, such that the final allocation is coalition-proof. Kofman and Lawarree (1996) develop a model in which it may be optimal for the principal to allow for collusion. However, this result is obtained because deterring collusion is costly in their model. In contrast, in our model, even if it is costless to prevent collusion, allowing for collusion between management and director can be beneficial to the principal. Our argument is developed in the following steps. Section 2 presents the basic model. In Section 3, we study from the shareholder’s point of view the ideal benchmark case where the shareholder after one period observes the manager’s type and his firing cost, and from the start can commit to a firing rule based on the realisation of the firing costs.
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